Tuesday, August 09, 2011

What's fair in taxation?

By request I'm taking this excahnge in a different comment thread and putting it up here for general discussion:

MCN: Business are taxed on profits regardless of whether they are reinvested in the company or dividended. ... One of the exceptions is that they are NOT taxed on overseas profits until they are repatriated to the US, at which they are subject to the usual corporate tax rates. The US is one of the very few countries that taxes income earned abroad.

There is a lot of cash sitting overseas because confiscatory US corporate tax law discourages repatriation. For my part, one of the necessary solutions is to meaningfully reform the corporate tax code by eliminating many deductions while reducing the tax rate.

In addition, there should be no tax on dividend income.

ZORN: You can really get yourself wrapped around the axle if you try to discern perfect logic in the tax code or, in fact, to apply logic to it.

Basically, as I see it, taxation at every level is about drawing enough money out of the system -- transactions and holdings -- to run that system, and doing so in a way that puts the least friction on the system.

We could, after all, simply divvy up the total cost of government equally among every citizen and levy bills -- federal, state, county, local -- accordingly. Completely fair but of course unthinkable.

At the other extreme we could tax every dollar earned over a certain amount to the extent necessary to run things. That might be $300,000 a year, say. Not fair and, again, unthinkable.

Tax systems ultimately meet between these extremes, and the "right" answer depends on what you perceive as desirable and most fair. I'm sure you have a theoretical argument to make for eliminating taxes on dividend income ... it incentivizes investment or something like that.

But why should that income of Sandy Trustfund be favored over the income of Pat the bricklayer?

Posted at 11:57:33 AM

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ZORN REPLY -- But there is a value judgment implicit in the tax-free "gift" vs. the taxed work-for-pay transaction. If Deadbeat Relative comes to my door and says "give me money" and I give him $10,000, he'll owe no tax on that. If Industrious Relative comes to my door and says "I'll paint your house and wash your windows and build you a tool-shed for $10,000" he'll owe income tax on that. Why does that make any sense at all?
I do think charitable donations should not be deductible as a matter of principle -- those of you are opposed to govt. deciding winners and losers, making value judgments, meddling with the free marketplace etc., and who think things are more hunky dory for all when the govt. doesn't meddle ought to be cheering this. But as a practical matter I sense this would be a disaster for organizations that do good work.

GREG J REPLY -- As MCN correctly points out, the giver is taxed on the gift. The worker, by contrast, is taxed on his net income. This makes sense, at least to me, because we view gifts as extensions of the donor's wishes while income is viewed as earned by the worker. I would get rid of the gift tax because I think that one should be able to transfer wealth as he pleases. Of course the recipient would be enriched without paying tax (just as he is today) but, again, we've run into the flaw with an income tax system vs. a consumption tax system.

I'm betting the IRS collects very little in gift taxes but I would be very careful if I was going to ignore the law there. The penalties can be harsh. Also, contest winnings are different from gifts. I think there's a special 1099 for those.

ZORN REPLY -- I'm stunned by this assertion, which checks out with online sources, since many times I've read where people who win stuff on game shows or are, say, given cars by Oprah Winfrey are liable for the taxes on the value of those gifts. Perhaps talk-show booty is in a different class, but I can't begin to fathom the reason that the giver has to pay the tax other than it may be an easier way to police collections.
I'd be curious, given the fairly generous annual exemption, just how much money the IRS collects each year from gift givers paying taxes on the amounts of the gifts they have given.
I'd guess the number is, for all statistical and practical purposes, zero.

MCN Reply: See, Eric? I just don't make sh*t up. Also, game show winnings are considered income, not gifts, and are taxable to the recipient, although I don't see how the Oprah thing would fit in. I would have thought she would have had to pay gift taxes on it.

I read on a site that may or may not be reliable that in 2006 IRS collected about $26 bil in estate and $2 bil in gift tax. That was about 1.1% of all taxes collected, including individual, corporate, employment, excise, etc. I wonder how many tens/hundreds of millions were spent on professional fees in trying to avoid/minimize the tax?

I believe gift taxes were created to prevent wealthy individuals from giving away that wealth before they died, avoiding the so-called death tax. Since then, the percentage of 'estate' taxes has come down, while the exemption has risen to $5 million. I believe the gift tax exemption is around $13,000?

I find it hard to believe if Jimmy Page (Zeppelin Rocks!) gave MCN one of his valuable guitars, he wouldn't be liable for the gift tax, if he were an American citizen. What if he gave MCN a Monet painting? Both objects are clearly investment art.

I also find it hard to accept estate income shouldn't be taxed in some form, it IS income, if I win the same amount in the lottery, I'll be taxed.

Tax deductibility for gifts:
"Pursuant to 26 U.S.C. § 102(a), property acquired by gift, bequest, devise, or inheritance is not included in gross income and thus a taxpayer does not have to include the value of the property when filing an income tax return. Although many items might appear to be gift, courts have held that the most critical factor is the transferor's intent. Bogardus v. Commissioner, 302 U.S. 34, 43, 58 S.Ct. 61, 65, 82 L.Ed. 32. (1937). The transferor must demonstrate a "detached and disinterested generosity" when giving the gift to actually exclude the value of the gift from the taxpayer's gross income. Commissioner of Internal Revenue v. LoBue, 352 U.S. 243, 246, 76 S.Ct. 800, 803, 100 L.Ed. 1142 (1956). Unfortunately, the court's articulation of what exactly satisfies a "detached and disinterested generosity" leaves much to be desired."

Apparently Oprah's gifts weren't based on detached or disinterested generosity. Gifts from employers are given the same treatment.

Eric, It's technical and I don't want to jargon this up (I'm a tax guy) so I want to suggest another way of thinking about your examples. In the Oprah example, she is not giving a gift - she is promoting her show. She (or GM or Ford or whomever) will get a deduction against their business income for the cost of those autos as a promotional expense. The recipient, by agreeing to participate in the promotion has earned the car as income. This is not a "gift".

In the house painting example, the rich relative has received something of value (besides just the intrinsic feel good value) and thus the painter has earned income. When you provide tangible value to someone else in exchange for money or other tangible consideration we tax this as income.

If instead the rich relative transfers something as a "gift", he/she doesn't get anything tangible in return.

I believe you are simply implying that we should rethink the whole system. It's a fair statement but the variety of real situations is much more complicated than the simple example you gave. For example, if my father is a famous painter and leaves me his priceless masterpiece as my sole inheritance, why should the government get 55%?

Can we tax George Clooney because he inherited better looks and talent than I did? I wouldn't want to but when he uses those "gifts" to earn money it's fair game.

***THEODORE DALRYMPLE
British Degeneracy on Parade
The riots should surprise no one who’s been paying attention.***

[The riots are the apotheosis of the welfare state and popular culture in their British form. A population thinks (because it has often been told so by intellectuals and the political class) that it is entitled to a high standard of consumption, irrespective of its personal efforts; and therefore it regards the fact that it does not receive that high standard, by comparison with the rest of society, as a sign of injustice.]

From what I remember, after it was determined that the Oprah car recipients did have to pay taxes on the cars, the Oprah show made arrangements to take care of that (paying the additional tax). That amount would be most likely have been grossed up for the taxes on THAT amount, which would have taken care of it, as far as I can tell.

"According to a spokeswomen for Harpo Productions Inc., Oprah's company, the recipients must pay a tax on the winnings, just like any prize...The Harpo Spokeswomen said winners had three choices. They could keep the car and pay the tax, sell the car and pay the tax with the profits or forfeit the car."

ZORN REPLY -- I fail to see, then, how a minimally competent tax attorney couldn't arrange for an expensive gift to be a "prize," thus foisting the tax liability onto the recipient.

At the same time, and I know we've gone over and over and over this, I fail to see why any one form of transition of wealth or goods from one person to another shouldn't presumptively be taxed at the same rate as all others. That is, if I give you something worth $1,000, why does it matter to the transactional tax person WHY you've given it to me? As a prize, as a gift, as a promotion, as wages?
Why, if I'm a lawyer and spend five hours performing $1,000 in services for you, do you pay no sales tax. But if I'm a well known artist and spend five hours slapping paint on a canvas for you, you must pay a sales tax on top of the $1,000 price of my painting?
And this gets to my issue with consumption taxes -- unless they expand greatly to cover all kinds of services, they miss a lot of commercial activity.
The whole area fascinates me so much I really ought to know more about it.
For instance, answer me this: If I'm pals with Derrick Rose and he signs a basketball for me and that signed basketball is worth $500 on the collectors' market, can I write $500 off my income for tax purpose as a charitable donation if I turn around and give that ball to a charity auction?
What if Derrick Rose eliminates the middle man and simply gives a ball he has signed to the charity auction? Can he take a $500 deduction on his income?
What if I own a rare gold doubloon that's been in my family for 100 years and is worth $550. Same tax deduction as for the ball?
If I have a friend come and live with me for the summer and, to earn his keep and express his gratitude he paints my house, re-builds my shed and puts down paving stones on my walk, is this a taxable bartering event in which we both legally ought to pay taxes on the value of services/accommodations rendered?

Take your Derrick Rose example: one could argue that, when he signed it, you received $500 in income, so when you donate the ball, it's a wash on your taxes. Does Derrick have to pay gift tax if he signs 35 balls on one day?

I don't think any tax lawyer could convert an intra-family gift into a prize.

Re your question about transference of assets/cash, the characterization of the transaction determines the tax rate. The application of sales tax to services is currently a matter of state tax law. There may or may not be different applications of sales taxes to professional services vs., say, auto repairs and painting. I can't recall.

Remember that capital gains taxes are paid only when an asset is sold. I think that your gold doubloon, had you sold it, would have been taxed at the CG rate, which you don't have to pay because you donated it and you get the deduction as an offset to ordinary income.

Finally, I think as a matter of policy it is a very bad idea to tax estates and gifts, for reasons I have stated before (I don't think there should be a tax on death, which the estate tax is), and the taxes encourage too much unproductive planning and have a tendency to send the assets in more unproductive places than if there had been no tax.

Put another way, when a successful businessman dies, leaving a firm with a going concern value of, say, $20mil, and he leave it to his family, I see no need to tax that occasion. If the family sells the business, it would be taxable at a capital gain rather than the rapacious inheritance tax, which makes this tax all the more execrable

Let's look at this even more for a moment. Say Mr. Smith sells his auto dealership for $20 mil and cashes in. He will pay capital gains tax on the difference between his basis and what he sold it for.

Let's say his profit is $15 mil. He pays cap gains at 28%, plus state. The next day he dies. His family now pays inheritance tax. The business is taxed twice, once when he sold and then when he died. This is sensible? His family would have been better off if he never sold because they would have avoid the CG tax.

Insanity.

ZORN REPLY-- Bad tax lawyering, it sounds like to me. All you're talking about in this instance is taxing the transfer of wealth from party A who buys the business to party B who sells it (the sale of the business). Then the transfer of wealth from party B, the person who holds the proceeds, to party C, which happens to be a family member.
Who pays the tax on the transaction? IN effect, party B the first time, party C the second time. It requires a lot of handwaving to pretend that Party B pays both taxes. Money is taxed at each step along the way, right?

"Why, if I'm a lawyer and spend five hours performing $1,000 in services for you, do you pay no sales tax. But if I'm a well known artist and spend five hours slapping paint on a canvas for you, you must pay a sales tax on top of the $1,000 price of my painting?"

In most cases that I know of, services aren't taxed, aren't those costs figured into whatever fee you're charged? Like services provided by lawyers, doctors, auto mechanics, etc. You will pay taxes on the transfer/purchase of objects, like paintings, auto parts, eyeglasses, etc.

As for your work example, many provide services in exchange for, say, living accommodations. Unless there is a paper trail provided by either side to the IRS, as to costs, materials, labor, this is not an issue, something many illegals and the people they work for depend upon.

As for your basketball and coin examples, you can pass these things along as many times as you want, until you attempt to deduct them as charitable contributions. You paid nothing for either of these objects, why should the IRS know about them? That basketball cost you twenty dollars, you were taxed at time of purchase, Rose signing it later means nothing unless you try to benefit from his fame. I think rare coins and art objects can't be taxed unless they're first assessed, then sold. I'm probably wrong, but many valuable objects came to me through my grandparents, I didn't pay any tax, neither did they, will I have to pay tax if I cash them in?

I think the Tax Code stinks, the wealthy have greater opportunities to avoid paying tax through loopholes available to them. People who make lesser incomes don't have that luxury or the money to hire smart lawyers to show them how to avoid the tax traps, so the cars Oprah gave away weren't either free nor available to the people who could not come up with tax fees.

Wendy,
Even with loopholes the wealthy pay the bulk of the Federal Income taxes: Take a look at the numbers http://ntu.org/tax-basics/who-pays-income-taxes.html. The distribution of the tax burden doesn't seem to be an issue here. It is hard to claim that it is unfair at a macro level, relative to incomes in aggregate (and the resulting aggregate consumption, as it is undoubtedly even more progressive with respect to consumption). The issue is the perversity of the tax code as far as what incentives it creates, its non-neutrality with respect to different types of economic activity. There is a lot of unfairness at a micro level, which is the level on which we all live and what adds up to the economy.

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